Chapter 9 -Tutorial Solutions FIA 3271 Introduction to Finance

Chapter 9 (Tutorial)- Solutions

1. The cost of capital in layman is the minimum return a company needs to make
from its investments to satisfy its investors and creditors.

It is equal to an average of the individual costs of financing used (bonds, preferred

stocks and common stocks) by the firm.

The firm’s cost of capital (weighted average cost of capital) is a function of the
individual cost of capital and the capital structure mix.

2. Weighted Average Cost of Capital is used a benchmark for the company to

evaluate either to invest or not in a new project.
When a company is thinking about investing in a new project, it compares the
expected returns from that project to the WACC. If the project is expected to make
more money than the WACC, it’s worth doing. If it’s less, it’s not.

3. When a company borrow money, it has to pay interest on that debt. Because
interest is a tax-deductible expense, the company can subtract the interest
payments from its taxable income, reducing the amount of tax payment and
effectively lowering the cost of borrowing.

Since the cost of debt is part of the overall cost of capital (WACC), a lower after-
tax cost of debt reduces the WACC.

4. Flotation costs are the expenses that a company incurs when it issues new
securities, such as stocks or bonds. These costs can include underwriting fees,
legal fees, registration fees, and other associated expenses.

The presence of flotation costs can have a significant impact on a firm's weighted
average cost of capital (WACC).

When a company issues new equity (stocks), flotation costs reduce the net
proceeds that the company receives from the issuance. This effectively increases
the cost of equity because the company must generate a higher return to cover
these additional expenses.

Since WACC is a weighted average of the costs of equity and debt, an increase in
the cost of either due to flotation costs will increase the overall WACC.

5
a.
n 10
PMT 90

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Chapter 9 -Tutorial Solutions FIA 3271 Introduction to Finance

PV -1045
FV 1000
rate 8.32%

Kd after tax = 8.32% x (1-30%)= 5.82%

b. kncs = +g

= + 0.07
= 0.1437 = 14.37%

c. kcs = +g

= + 0.07
= 0.1514 = 15.14%.

d. kps = =

=
= 0.0877 = 8.77%

e. = kb (1 – T)

= 12% (1 – 0.21)
= 9.48%

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Chapter 9 -Tutorial Solutions FIA 3271 Introduction to Finance

6. kcs = +g

=
= 0.1838 = 18. 38%
7. Given
Cash $ 540,000
Accounts Receivable 4,580,000
Inventories 7,400,000 Long-term Debt $12,590,000
Net Property, Plant & Equipment 18,955,000 Common Equity 18,885,000
Total Assets $31,475,000 $31,475,000

Cost of debt financing 8%

Cost of equity 15%
Tax rate 21%
Market to book ratio 1.00

Solution
Market Value

Component Proportion After-tax Cost Product Balance Sheet

Long-term Debt 40% 6.32% 2.53% $ 12,590,000
Common Equity 60% 15.00% 9.00% 18,885,000
11.53% $ 31,475,000
b.
Given

Cash $ 540,000
Accounts Receivable 4,580,000
Inventories 7,400,000 Long-term Debt $12,590,000
Net Property, Plant & Equipment 18,955,000 Common Equity 18,885,000
Total Assets $31,475,000 $31,475,000

Cost of debt financing 8%

Cost of equity 13%
Tax rate 21%
Market to book ratio 1.50

Solution
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Chapter 9 -Tutorial Solutions FIA 3271 Introduction to Finance

Market Value Market Value

Component Proportion After-tax Cost Product Balance Sheet
Long-term Debt 30.77% 6.32% 1.94% $ 12,590,000
Common Equity 69.23% 13.00% 9.00% 28,327,500
10.94% $ 40,917,500

8. Carion Corporation—Weighted Cost of Capital

Capital Individual Weighted

Structure Weights Costs Costs

Bonds $1,083 0.2152 5.5% 1.18%

Preferred stock 268 0.0533 13.5% 0.72%
Common stock 3,681 0.7315 18.0% 13.17%
$5,032 1.0000 15.07%

9 Given

Cash $ 2,010,000
Accounts receivable 4,580,000
Inventories 1,540,000 Long-term debt $ 8,141,000
Net property, plant, and equipment32,575,000 Common equity $32,564,000
Total assets $40,705,000 Total debt and equity
$40,705,000
Cost of debt financing 8%
Cost of equity 15%
Tax rate 21%
Market-to-book ratio 3.00

a. What does ABBC’s capital structure look like? Note that because the market-
to-book ratio (market value of equity to book value of equity) is 3, the market
value of the firm’s equity is 3 × $32,564,000 or $97,692,000. The market
value of debt is assumed to equal its book value. Thus,

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Chapter 9 -Tutorial Solutions FIA 3271 Introduction to Finance

Market Value
Component Balance Sheet Proportion After-Tax Cost Product
Long-term debt $ 8,141,000 7.7% 6.32% 0.49%
Common equity 97,692,000 92.3% 15.00% 13.85%
$105,833,000 14.34%

b. What is ABBC’s weighted average cost of capital? Based on the above

calculations, the answer is 14.34 percent.

c. If ABBC’s stock price were to rise such that it sold at 3.5 times book value and
the cost of equity fell to 13 percent, what would the firm’s weighted average
cost of capital be (assuming the cost of debt and tax rate do not change)?

Cost of debt financing 8%

Cost of equity 13%
Tax rate 21%
Market-to-book ratio 3.50

Market Value
Component Balance Sheet Proportion After-Tax Cost Product
Long-term debt $ 8,141,000 6.7% 6.32% 0.42%
Common equity 113,974,000 93.3% 13.00% 12.13%
$122,115,000 12.55%

d. The company would assume more debt financing, which will have a lower
after-tax cost.
10. Projects A, B, and C offer rates of return that exceed the firm’s 12 percent
cost of capital and are therefore acceptable projects. The rationale here
relates to the meaning of the cost of capital (or WACC) for the firm.
Specifically, the WACC represents the weighted average cost of its financing.
The firm needs to earn its WACC on each dollar of capital it uses in order to
satisfy the firm’s capital sources (debt and equity). As long as the firm earns
at least the WACC on each dollar invested, then the firm’s suppliers of capital

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Chapter 9 -Tutorial Solutions FIA 3271 Introduction to Finance

can be paid, and they will be happy. If the firm earns more than the WACC,
then the excess, by definition, goes to the firm’s common stockholders.
Higher-than-required rates of return on investment (i.e., as with projects A, B,
and C, which earn more than 12 percent) will result in stockholders’ bidding
up the price of the firm’s common stock because the firm is providing excess
returns to the common stockholders at the current stock price.